Situation and tax authority’s view

A company incurred costs for the servicing and maintenance of its photovoltaic power plant, which were provided to it by its Czech parent company through its employees. The tax authority considered the transfer prices of the services to be overstated and assessed additional tax on the subsidiary by reference to Section 23(7) of the Income Tax Act (‘ITA’).

The tax authority assessed the provided services as low-value-added routine intra-group services within the sense of the General Tax Directorate’s Decree no. D-10 on low-value-added services (‘Decree D-10’).

As the appropriate method for determining the arm’s length transfer price, the tax authority applied the Cost+ method, based on the parent company’s payroll costs (including social security and health insurance contributions) and added a mark-up of 7%, which is the maximum allowable mark-up under Decree D-10 (which sets the amount of customary mark-ups between 3% and 7%). According to the tax authority, this mark-up included a reasonable profit and other costs that may have been incurred in the provision of the services, which, according to the tax authority, the taxpayer did not specify sufficiently and could therefore not reflect them in the cost base.

The taxpayer requested the application of the CUP method, submitting quotations from independent companies providing similar services. At the same time, it argued that the tax authority failed to bear its burden of proof when it rejected a direct comparison with independent transactions using the CUP method and proceeded to an indirect comparison using the Cost+ method and the Decree D-10, even though the application of this method and the mark-up did not formally meet the quantitative criteria set out in the Decree D-10 for the application of the simplified approach (the condition of the proportion of costs incurred to the recipient’s operating costs, as formally set out in the Decree D-10, was not met).

The Court’s decision

Both the Regional Court and the Supreme Administrative Court sided with the tax authority. The SAC emphasised that, although the CUP method is the preferred method, it is only on the assumption that there are sufficiently comparable transactions between independent parties. In this case, however, the taxpayer did not provide sufficient evidence of the comparability of the services provided with reference transactions of independent parties. A key argument for the SAC’s assessment was that the taxpayer did not provide specific records of the services provided by the parent company (e.g., time reports showing which specific activities were performed, to what extent, number or volume, etc.). Without such information, no objective comparison could be made with independent transactions, and therefore the CUP method could not be reliably applied.

The SAC also addressed the distribution of the burden of proof between the tax authority and the taxpayer. The SAC confirmed that, although the burden of proof to prove the reference price lies solely with the tax authority, the taxpayer in the case at hand did not sufficiently prove which specific services it received from the parent company and therefore it was not possible to verify comparability with independent transactions. If the tax authority was to determine the reference price competently, and the use of the CUP method was precluded by the unclear content of the services provided, it had to determine the reference price with sufficient reliability by another appropriate method. The Cost+ method was then selected the most appropriate alternative method. In this way, the tax authority satisfied its burden of proof as regards the selection of method. The application of the Cost+ method could not then be prevented by the wording of the Decree D-10, since, according to the SAC, ‘what was essential was compliance with the law, namely a sufficiently reliable determination of the reference price in accordance with Section 23(7) of the ITA’.

The tax authority applied a mark-up of 7% only to labour costs, which should have covered not only a reasonable profit but also any other costs that the taxpayer had not sufficiently demonstrated. The SAC held that the taxpayer should have documented any additional costs itself if it wished to include them in the cost base. According to the SAC, the Cost+ method is intended to simplify the determination of the reference price for both the taxpayer and the tax authority, and it therefore agreed with such simplified application.

It is also worth noting another, albeit marginal in the context of the case under review, part of the dispute in which the tax authority disputed the price of a rent agreed with an executive who was also the chairman of the board of directors and the sole owner of the parent company, i.e. a related party for the purposes of transfer pricing. The tax authority determined the reference rental price using the CUP method and by analysing the rental prices of comparable premises offered by real estate agencies. The tax authority determined the rental price range in CZK/m²/year and selected the most favourable (highest) price for the taxpayer. Although these were offer prices, in this situation the SAC agreed with this approach.

The SAC also confirmed that the determination of the reference price does not constitute a question on which the administrative court would always have to appoint an expert. If the tax authority determines the reference price using one of the transaction methods (i.e. including, for example, the Cost+ method), the administrative court does not need to order an expert examination if it is able to review and evaluate the tax authority’s procedure. At the same time, according to the SAC, if the court sufficiently deals with the submitted expert opinion, there is no reason to prepare a revised expert opinion.

According to the SAC, the objection that there was a ‘group’ of Czech companies which jointly paid tax to the State at the statutory rate does not withstand either. According to the SAC, the tax authority properly established the difference between the agreed price and the reference price of the related parties and therefore assessed tax on the basis of that difference. The taxpayer in the present case was the audited company, not a ‘group’ of Czech companies. This company had formally failed to pay the correct tax, leading to the additional tax assessment, which the NSS upheld.

What does the SAC judgement imply?

Although this particular judgement was unfavourable for the taxpayer , the SAC agreed with the possibility of simplified application of the Cost+ method in the case of routine intra-group services. This is both in terms of applying the mark-ups considered typical by the Decree D-10 and in terms of simplified cost base determination. The SAC also agrees with the determination of the reference price for office space rentals based on offers from real estate agents. This can be seen as positive in certain situations.

At the same time, the decision shows that the specific content of the services provided by the parent company was not clearly demonstrated. This may raise questions about the taxpayer’s ability to bear the burden of proof in relation to proving the general tax deductibility of services under Section 24(1) of the ITA. Although this has not been disputed, the test of general tax deductibility usually precedes the transfer pricing test and only then does the burden of proof shift from the taxpayer to the tax authority. Taxpayers should therefore remain very vigilant in the case of intra-group services and should be able to justify in detail the extent of the services received, while the tax authority’s requirements in this area remain very extensive.